Before You Invest in the Latest IPO, Read This
Whenever a high-profile company goes public, investors inevitably ask the same question:
"Should I buy it?"
The excitement is understandable. Media coverage increases, social media lights up, and stories begin circulating about the potential for significant gains. For many investors, an Initial Public Offering (IPO) feels like an opportunity to get in on the ground floor of the next great company.
Before getting caught up in the IPO frenzy, however, it is important to understand both the opportunities and the risks that come with investing in newly public companies.
Investor Ken Fisher jokes that IPO historically stands for "It's Probably Overpriced."
While intended as humor, the quote highlights an important reality: companies typically choose to go public when market conditions are favorable and they believe they can maximize the value of the shares being sold. In other words, the timing of an IPO is generally intended to benefit the company and its existing owners, not necessarily the new shareholders purchasing the stock.
That doesn't mean every IPO is a bad investment. Some newly public companies go on to become successful businesses and rewarding investments. However, history shows that many highly anticipated offerings disappoint investors during their first few years as public companies.
Why Investors Should Approach IPOs Carefully
Limited Information
Unlike established public companies, newly public companies have little or no history operating under the scrutiny of public markets.
While investors have access to prospectuses and other disclosures, there is often less information available than there is for companies that have spent years reporting results as public entities. As a result, investors may be making decisions with greater uncertainty than they realize.
Optimistic Valuations
Companies generally choose to go public when demand for their shares is expected to be strong. This often results in IPO prices that reflect high expectations for future growth.
The challenge is that even strong companies can struggle to meet lofty expectations. If future growth falls short of what investors anticipated, the stock price can decline even if the company itself continues to grow.
Significant Volatility
Newly public stocks often experience substantial price swings during their first days, weeks, and months of trading.
Excitement, media attention, analyst coverage, and speculation can all contribute to dramatic price movements. Investors who buy based on momentum may find themselves exposed to more risk than they expected.
Lock-Up Expiration Risk
Many investors are unaware of a unique risk associated with IPOs known as a lock-up period.
Following an IPO, company founders, executives, employees, and early investors are often prohibited from selling their shares for a specified period of time, commonly 90 to 180 days. When those restrictions expire, a large number of shares may become available for sale.
This increase in supply can sometimes place downward pressure on the stock price, even if the company's business fundamentals remain unchanged.
Uncertain Profitability
Many IPO companies are still working toward sustainable profitability.
Investors are often paying today's prices based on expectations of future earnings that may take years to materialize or may never materialize at all. While some companies eventually justify those expectations, others struggle to achieve the growth and profitability investors anticipated.
Behavioral Risk
Perhaps the greatest risk surrounding IPOs is not financial but emotional.
When a company is receiving constant media attention and everyone seems to be talking about it, investors can feel pressure to act quickly for fear of missing out. Unfortunately, investment decisions driven by excitement or fear often lead investors away from a disciplined long-term strategy.
The Challenge Isn't Identifying a Great Company
One of the most common misconceptions about IPO investing is the belief that if a company becomes successful, buying its IPO must have been a good investment.
Unfortunately, that's not always true.
A company can be an extraordinary business and still be a disappointing investment if its stock was purchased at too high a price. Successful investing requires not only identifying a great company but also paying a reasonable price and having realistic expectations for future growth.
This distinction is one reason many investors underestimate the challenges associated with IPO investing.
A Different Approach to Investing
At Hammond Iles Wealth Advisors, we generally do not recommend investing in individual stocks, especially newly issued IPOs.
Instead, we believe prudent investing is built around globally diversified portfolios aligned with an investor's risk tolerance, time horizon, and financial objectives.
Rather than trying to predict which individual companies will become the next great success story, diversified investors participate in the growth of thousands of companies around the world.
It is also worth remembering that diversified investors do not need to correctly identify tomorrow's winners in advance. As successful companies grow and become part of market indexes, diversified portfolios naturally participate in their success. This allows investors to benefit from innovation and economic growth without taking the concentrated risk of betting on a single company.
The Bottom Line
The excitement surrounding a new IPO can be powerful. But successful long-term investing is rarely about chasing what is popular today.
More often, it is about following a thoughtful plan, staying diversified, managing risk appropriately, and remaining focused on long-term goals.
Before investing in the latest IPO, take time to understand not only the company's potential but also the unique risks that come with investing in newly public stocks. A disciplined investment strategy may not generate headlines, but history suggests it has a much better chance of helping investors achieve their long-term financial goals.